"We did not expect this." That was the initial reaction by
Jamie Baker and crew at J.P. Morgan's North America Corporate research team yesterday
following news of the U.S. government's decision to file suit against the
planned American Airlines-US Airways merger. It is a sentiment shared by many. The
prevailing wisdom had been that the last piece of the U.S. air industry consolidation
puzzle nearly was in place, and if there were any additional hurdles to overcome,
they would come in the form of specific concessions demanded by regulators. Instead,
the U.S. Department of Justice's Antitrust Division said it is bent on achieving
a "full-stop injunction."

This development is bad news for American, which seemingly had a clear
path to emerge from bankruptcy, for US Airways, which had built its future on the
merger, and possibly for the U.S. airline industry at large.

"The industry's longer-term earnings
prospects are jeopardized by a standalone AMR business plan that must grow its way
(rather than merge its way) to competitive network parity with post-merger Delta
and United," according to the J.P. Morgan analysts.

According to Fitch Ratings, improvement in airline credit rating profiles
during the past several years had been "driven by
a more sustainable industry structure, with a smaller number of stronger carriers
benefiting from disciplined capacity management practices, higher passenger yields
and better revenue fundamentals. The DOJ complaint, which specifically identifies
potential injury to consumers resulting from reduced competition and higher fares,
may indicate that further consolidation-related improvements in airline operating
profiles may not be achieved, at least in the near term."

Morgan Stanley analysts in a Wednesday research note wrote that DOJ's move "is unequivocally
an incremental negative vis-à-vis our attractive industry view." They also noted
that Delta and United "would
have a duopoly on corporate travel, superior networks and more valuable frequent-flyer
programs."

Without doubt,
AA as a standalone entity would be challenged to maintain effective competition
against its adversaries, but the impact on its larger rivals, or any others,
could be mixed.

"Capacity is likely to move higher, in our view, diminishing margins
along the way, while service levels are less likely to improve should carriers fail
to generate adequate returns and reinvest in the business," according to J.P.
Morgan analysts. "A network duopoly (Delta and United) where US Airways and
American increasingly need to fight for share is less desirable than a fair and
oligopolized industry (American, Delta and United in roughly equal portions). We
believe three is better than two, though clearly our views are at odds with the
DOJ."

They added that a scenario in which AA is forced to grow capacity to
reach parity with Delta and United "is likely to slow the industry healing
process from here, and potentially cause earnings in 2015 and beyond to come under
pressure should supply trends worsen. ... While competitor managements will very
likely try to assuage investors that they intend to remain disciplined when confronted
with a potentially growth-oriented AMR, we have our own doubts."

How Did We Get
Here?

DOJ said it had been scrutinizing the proposed merger for six months.

Bill Baer, assistant attorney general
for DOJ's Antitrust Division, during a Tuesday media briefing said, "The parties
told us that they wanted us to make a decision before Aug. 15," which is when
the court overseeing AMR's bankruptcy would have held a hearing on the plan of reorganization,
of course centered on the US Airways merger.

Though DOJ didn't move to prevent mergers between Delta and Northwest,
United and Continental, and Southwest and AirTran, it did oppose combinations proposed
around the turn of the century: United-US Airways (at least initially, before suggesting remedies) and Northwest-Continental. Baer also
noted that DOJ "looked very seriously at US Airways' [2006] hostile bid for
Delta before that was abandoned."

"So it's not the first time," he said, adding that "we
learned during our investigations about what happened to competition from prior
acquisitions."

But observers quickly picked up on how DOJ this time around expanded
its arguments. "DOJ has significantly altered its usual M&A analysis to
introduce connecting markets and baggage fees into its calculus," according
to J.P Morgan analysts. "Granted, connecting competition has been considered
in prior regulatory reviews, but in each case the incremental citypair connectivity
and improved customer service levels have overshadowed any potential loss of competition
in seemingly obscure connecting markets." They concluded that "the rules
of engagement appear to have been altered."

DOJ's complaint detailed its competitive concerns about a long list
of connecting markets, and Baer on Tuesday also addressed the issue of ancillary
fees.

"If the merger goes forward, consumers can also expect to pay
higher fees for things like checked bags, flight changes, more legroom and frequent-flyer
benefits," he said. For example, "today, American does not charge if you
redeem frequent-flyer miles. US Airways charges an average of $40. If the merger
is allowed, US Airways is planning to take this frequent-flyer benefit away and
make American's frequent flyers pay redemption fees. By eliminating this competitive
distinction between American and US Airways, the new airline generates an additional
$120 million in revenue. But you pay the price."

What's Next?

In short, months of litigation. Even if a compromise is hammered out,
the intended timing of both AA's emergence from Chapter 11 reorganization and its
planned merger with US Airways has been thrown out the window.

But a compromise appears unlikely.

"The
scale of the complaint, identifying potential harm to U.S. consumers broadly rather
than in specific markets, as seen in the 2010 merger between United and Continental,
suggests that changes in the merger plan's scale and scope may not be sufficient
to win approval," according to Fitch.

Given the
government's expanded focus, including fees and connecting markets, J.P. Morgan
analysts wrote that "it is hard for us to envision a meaningful regulatory
appeasement that US Airways-American could offer. That isn't to say it can't happen,
but the challenges appear formidable and the airlines might not even try."
They added that assessing the airlines' chances in court is "difficult,"
though they are "cautiously optimistic."

If the case goes to trial, it will be heard by Judge Colleen Kollar-Kotelly of the U.S. District Court for the District of Columbia.
According to that court, Kollar-Kotelly was appointed in May 1997.

Circling The
Wagons

Meanwhile, the expected volleys of both support for and opposition
to the DOJ move came in rapid-fire fashion following the news.

In a letter to employees, AA CEO Tom Horton
wrote that "we have maintained that the
merger is complementary (only 12 overlapping routes), that it provides significant
customer benefits and that it enhances competition in the airline industry. Since the DOJ has formed a
contrary view, the matter will now be settled by the courts. In the meantime, American
and US Airways will continue to operate as independent companies and competitors.
All recent leadership announcements for the new merged American will be on
hold until such time as the merger receives final clearance."

In a message to his company's employees, US Airways CEO Doug Parker
wrote that "we are extremely disappointed in this action and believe the DOJ
is wrong in its assessment. We will fight them. Other companies have found themselves
in similar circumstances and gone on to successfully close their merger. In light
of today's announcement, the companies no longer expect the merger to close during
the third quarter of 2013. However, we are hopeful that the litigation will be successfully
concluded and we will close the merger before year-end."

Representing AA's flight attendants, the Association of Professional Flight Attendants blasted DOJ's
decision, say its actions "are only serving to prop up the duopoly they created.
... Following major mergers of their own, Delta and United have emerged as the dominant
carriers in the aviation industry and their vast networks have attracted the high-value
business travelers airlines need in order to be profitable. Frequent flyers have
left American in droves in favor of carriers with more routes and destinations.
The American/US Airways merger will give these travelers a viable third option."

Similarly,
the Allied Pilots Association, representing AA's pilots, expressed disappointment.
"Consolidation has enabled our industry to stabilize after a round of Chapter
11 bankruptcies that were the result of various exogenous shocks, including terrorist
attacks, fuel price spikes and pandemics," according to APA president Capt.
Keith Wilson. "It makes no sense for the Justice Department to conclude now
that airline industry consolidation is somehow undesirable."

On the flip side, the Business Travel Coalition conveyed support for
the antitrust lawsuit. "DOJ shines
a spotlight on how uncompetitive and cozy U.S. airlines have become," according
to a statement from BTC chairman Kevin Mitchell.

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